SEC to Advisers: “Can You Hear Me Now?”

by Deborah Prutzman, The Regulatory Fundamentals Group LLC


A little over a year ago the SEC warned advisers that the game has changed and that the agency would begin to use a risk-oriented, holistic approach to scrutinize senior managers and the control environment within their firms. Today, the warning sirens are growing even louder as  SEC staff notes significant deficiencies in “presence” exams of newly-registered advisers.  In fact, up to 64% of examined advisers were found to have deficiencies in some key areas.  Commenting on this, the head of the New York SEC examination program admonished that there would be no leniency for new advisers who are not up on requirements.

It appears that, in an industry new to regulation, many are tone deaf to regulators’ signals about priorities and future activities — and even slower to appreciate how these priorities are likely to turn into actions in the weeks and months ahead.  Have no doubt about this: all signs indicate that enforcement initiatives will focus on senior management, which will include board members as well as C-suite executives.

In the first half of this article we discuss what the SEC is trying to communicate.  In the second part we offer a short test senior management should take now to determine whether they and their firm are at risk in the short-term.

The “warning sirens” referred to above are clearly manifested in the SEC’s 2013 examination priorities; in a December speech by Bruce Karpati, the head of SEC Enforcement Division’s Asset Management Unit; and in a February speech on recent adviser examinations by Ken Joseph, the head of the SEC’s Investment Adviser and Investment Company Examination Program for the New York region. Taken together, they signal that areas of intensifying scrutiny will include:

Governance.  Corporate governance, enterprise risk management and their related systems of internal checks and balances were mentioned as critical in each of these communications. The lack of independent governance at many hedge funds makes them, in the eyes of the SEC, more susceptible to conflicts of interest (especially conflicts concerning compensation, valuation and allocation), technology oversights and other concerns.  The SEC’s scrutiny of fund governance will increasingly focus on the relationship between the adviser and fund boards, including how boards receive and review information. Tailored, as opposed to “off the shelf,” compliance programs are a key enhancement for advisers in this area. A related area of concern is that the CCO has a firm understanding of obligations under relevant laws and regulations.

Conflicts of interest. Related to governance, the SEC will be looking for the “overall risk governance framework” that a firm uses to manage conflicts on an “ongoing basis.”  Reminiscent of statements out of the UK, the SEC will be examining conflicts arising from outside business activities, compensation arrangements, allocations of both investment opportunities and expenses between a fund and the adviser, and other areas where a fund manager might put personal interests ahead of investors or engage in self-serving transactions (for example, to hide losses). Management teams will need to identify areas of conflict on a proactive basis and be prepared to describe how they are addressed. Boards should do the same.

The SEC’s lens on conflicts will also focus on valuations.  Here the SEC will scrutinize the incentives to overvalue assets in order to boost compensation or to encourage sales of fund interests.  Areas to be examined will include inadequate valuation policies, the use of side pockets to conceal losing positions, the failure to follow stated valuation procedures, and policies relating to performance that may create valuation pressures. Expect examinations to focus on allocation practices, arrangements made with affiliated broker dealers, undisclosed compensation arrangements, soft-dollars, and best execution in order to determine if any improper benefits are given.

Marketing. Efforts to market funds will also be closely reviewed by exam teams.  In Ken Joseph’s recent speech, he noted that 38% of all recently examined advisers had marketing deficiencies. The deficiencies included impermissible advertisements, failing to put policies in place to oversee advertising content, cherry picking of performance data from higher-performing funds, and the inclusion of false statements. The pressure to disseminate attractive past performance information is always a major area of focus.   With respect to the JOBS Act, once the final rule is adopted, examiners will concentrate on the changes that a firm made to advertising guidelines as a result of the new rule.  Enforcement activity in the marketing space is clearly on the up-tick.  Only last week the SEC fined two private equity fund-of-funds advisers for marketing a new fund with materials that misrepresented valuation methods and how performance was determined.  (It did not help that the materials were revised after being reviewed by compliance.) The SEC also recently concluded an enforcement action centered on the use of an unregistered “finder” to solicit investors.

Informational edges. In Karpati’s speech, he stated that hedge funds may be “desperate to get an informational edge on the market,” and warned them not to do so through illicit means.  The SEC’s heightened focus on these issues is even more notable due to the SEC’s new technology-based tools for analyzing trading data and the participation of the FBI, which played a major role in the recent wave of successful insider trading prosecutions and is now involved in the investigation of high-frequency trading practices.

As the above statements by the SEC indicate, alternative advisers have moved from a relatively unregulated corner of the financial services industry to a heavily regulated position — and the trend towards increased scrutiny will likely continue.  Mastering the regulatory framework, at least on a high level, is a fundamental business skill that cannot be ignored.   Once acquired, this understanding must be communicated in a meaningful way to the employees who need to navigate regulatory requirements on a day-to-day basis.  This does not mean that everyone needs to become a regulatory expert.  However, it does mean that a firm whose staff members are unaware of the key “rules of the road” is putting itself, its management, and their fellow employees at risk.

For those who are uneasy about whether their house is in order, a short test follows below.  Spend two minutes to take the test and leave with a firm understanding of whether you are well positioned to navigate the new regulatory environment.


Your personal “mock audit”

For managers interested in evaluating the effectiveness of their firm’s compliance and other legal risk management initiatives, take the personal “mock audit” below.   Just as a routine check-up at the doctor’s office can prevent a medical emergency, taking this five-minute “mock audit” can help detect a regulatory problem.  The questions are not technical. Ready?  Read on.
Culture of Compliance
(Answer the questions below with a ranking from 1 to 5, with 5 representing the highest possible agreement.)
  1. Your management team believes that governance processes are important and that proper governance includes risk management of legal and compliance issues.
  2. Your chief compliance officer has respect, influence and independence in your organization.
  3. When risk and compliance personnel raise issues that concern a major profit driver, their concerns are promptly heeded and carefully investigated.
  4. Your chief compliance officer reports to/has direct access to your governing body or executive committee.
  5. Each of your staff functions understands the legal, contractual and regulatory requirements that are relevant to their role.
Out of a possible total of 25, what is your score? Ideally the score should hit the 20-25 range.  If the sum of your answers to the above statements is less than 17, consider whether your firm has significant exposure to legal and regulatory risks. Just as information about critical financial challenges needs to quickly go “up the chain”, it is equally important that senior management be informed about, and weigh in on, regulatory and legal issues.  An effective process to identify and escalate legal and compliance risks helps assure that decisions are made at the right level of management, with a full appreciation of all their potential ramifications.The true test of a culture of compliance does not lie with the support staff. It hinges on whether there is meaningful buy-in from profit centers and investment personnel.  For this to occur, they must be assured that doing the right thing is important to senior management, and that compliance personnel are respected and feel empowered to speak up — even when profits are at stake.Also, an effective framework must be established to coordinate the work throughout the firm, to reinforce the message and to facilitate escalation of issues –particularly in those instances where business and control groups may have differing viewpoints.  To have this type of constructive dialogue, staff must understand what is expected of them, which means that management must take the time to explain the key regulatory and contractual requirements that are relevant to the roles served by each staff function. It must be clear that certain lines are not to be crossed, whatever the staff’s specific objectives may be.

Legal and Regulatory Compliance
(Answer these questions yes or no.)

  1. Have you attempted to identify all the laws in all jurisdictions that apply to your firm, your clients, their investors and your investments?
  2. Is there a process for keeping the information gathered in #1 current and up to date reflecting both changes to laws and new activities undertaken by the firm?
  3. Is your compliance manual tailored to your business so that it covers all regulatory requirements, not simply those required by the SEC or CFTC?
  4. Do you and your employees refer to your compliance manual in order to obtain guidance/clarity on unusual or tricky situations?
If the answer is “no” to any of these questions, you need to address the situation now.In a heavily regulated environment, appropriate vigilance is crucial. Closing your eyes to regulatory requirements is like deciding to cross the street with your eyes closed.  Inattentive folks can be hit by an enforcement proceeding — or a truck, as the case may be.  Every organization needs to make an effort to determine which laws apply to it. Conducting an initial legal risk assessment and updating it periodically ensures that the firm develops procedures and processes specific to its organization. Once the firm has implemented a system for complying with requirements identified in its initial risk assessment, it must remain up-to-date on changes. Thus, the risk assessment becomes an on-going process.Managers sometimes think that it is enough if their firms have a compliance manual.  Many times these manuals, in the case of a U.S.-based adviser, focus only on SEC rules and regulations, without offering a broader coverage of the key risks facing the firm. Having a compliance manual is not the “be all, end all.” An outdated, ignored or off-the-shelf compliance program that is not customized to the business is not sufficient. When examining the effectiveness of the firm’s compliance manual, it is important to check whether it is meaningful to the business and actually followed by staff.  A great measure of a compliance manual is frequency of use.

Why do these questions in this short “mock audit” matter?  The business world is undergoing a powerful regulatory shift in which regulators, the press and investors have less tolerance for regulatory and risk management oversights. Expect this trend to continue for the foreseeable future, at least. Now is the time to get your house in order. When employees take their responsibilities seriously, a compliance program can protect employees, the firm, and its investors.



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